The Financial Reporting Council (FRC) has recently published an updated version of the UK Corporate Governance Code (Code) following its previous consultations. Key points to note include:
changes in relation to going concern including a new requirement to produce a viability statement;
a new monitoring requirement in respect of risk management and internal control systems;
remuneration policies should promote the long term success of the company and there is a new "comply or explain" provision in respect of clawback arrangements; and
companies should confirm how they intend to engage with shareholders following a significant vote against a resolution.
The FRC has also published final versions of the supporting guidance on risk management, internal control and related financial and business reporting (Guidance) and revised auditing standards alongside the Code.
The updated Code and Guidance will apply to accounting periods beginning on or after 1 October 2014.
Revised UK Corporate Governance Code
The FRC has adopted, without further amendment, its proposed changes to the Code provisions on going concern. Companies will be required to make 2 separate statements:
a Going Concern Statement: this should state whether the company will adopt the going concern basis of accounting and identify any material uncertainties in their ability to continue to do so over a period of at least 12 months from the date of approval of the financial statements; and
a Viability Statement: this is a broader assessment of the viability of the company. The statement should take into account the factors considered when making the assessment (such as the company's current position and principal risks), the time period that it covers and whether the company will be able to continue in operation and meet its liabilities. The FRC states in the Guidance that the viability statement should look forward significantly beyond 12 months.
The FRC recommends that the statements are contained in the strategic report so that they are covered by the safe harbour provisions in section 463 (liability for false or misleading statements in reports) of the Companies Act 2006.
The FRC has also taken forward its proposals in relation to risk management. The current requirement to review the effectiveness of risk management and internal control systems at least annually has been supplemented by an ongoing requirement to monitor those systems. The relevant Code provision has been amended so that monitoring as well as review covers all material controls, including financial, operational and compliance controls.
Remuneration linked to long-term success
Remuneration policies should be designed to promote the long-term success of the company. Remuneration committees should take the lead in ensuring that remuneration policies achieve this aim and do not encourage excessive risk-taking. The wording around being able to "attract, retain and motivate" directors, which potentially implied a different emphasis, has been deleted. The remuneration committee should consider requiring that directors hold a minimum number of shares and for a fixed period (even beyond their departure) where shares form part of the remuneration package.
Transparency in performance related elements of remuneration
The word "transparent" has been added by the FRC to ensure that performance related elements of executive remuneration are "transparent" as well as stretching and rigorously applied.
Caution should be exercised when using comparators
The remuneration committee should judge where to position their company relative to other companies but should exercise caution when drawing comparisons with other companies. This is to avoid an upward ratchet of remuneration levels with no corresponding improvement in corporate and individual performance which the FRC perceive as a risk.
There was much support for a new "comply or explain" provision in respect of arrangements that would enable companies to recover or withhold variable pay (such as bonuses and long-term incentives) in certain circumstances. Companies should also consider appropriate vesting and holding periods for deferred remuneration. The FRC acknowledged concerns raised around the enforceability of clawback mechanisms but argues that such mechanisms remain important regardless of the enforceability issues.
Companies should review current packages to determine whether any changes should be made in light of the Code. The FRC has declined to take the lead by providing examples of the circumstances in which it would be appropriate to use clawback mechanisms. It will be interesting to monitor how market practice and shareholder expectations develop on this issue.
Shareholder relations – votes against a resolution
Companies should confirm how they intend to engage with shareholders when a "significant proportion of votes have been cast against a resolution". In response to feedback, the FRC has clarified the wording so that this does not include votes withheld but only votes cast against the resolution. There is no definition of "significant proportion" so the board will need to make a judgment call on this.
The FRC's intention is to change behaviour so that companies explain how they intend to engage with shareholders in order to assess their concerns (rather than setting out how they intend to respond to those concerns).
Reissued Supporting Guidance
The Guidance revises, integrates and replaces the current editions of the "Internal Control: Revised Guidance for Directors on the Combined Code" (previously known as the Turnbull guidance) and the 2009 "Going Concern and Liquidity Risk: Guidance for Directors of UK Companies". The FRC has made changes to the Guidance to reflect the final wording of the Code. The Guidance will also apply to accounting periods beginning on or after 1 October 2014.
The Guidance partly reflects Lord Sharman's proposals. In 2012, the Sharman Inquiry concluded that the board's assessment as to whether a company remains a "going concern" should be more broadly based than is required to determine whether to adopt the going concern basis of accounting in the current financial statements and identify any material uncertainties about the company's ability to continue to do so in future.
Purpose of the Guidance
The Guidance is designed to assist directors apply to the relevant sections of the Code on going concern and risk. The aim of the Guidance is to:
bring together elements of best practice for risk management;
prompt boards to consider how to discharge their responsibilities in relation to the existing and emerging principal risks faced by the company;
reflect sound business practice, whereby risk management and internal control are embedded in the business process by which a company pursues its objectives; and
highlight related reporting responsibilities.
Separate guidance for the banking sector
The FRC has published separate guidance which contains supplementary considerations for the banking sector and which should be read in conjunction with the Guidance.
Revised auditing standards
The FRC has also published revised auditing standards (ISA 260, 570 and 700). Minor revisions have been made to the exposure draft published in November 2013 to reflect the final form of the Code. These include requiring auditors:
to consider and report on narrative disclosures including risks; and
to take into account the going concern basis of accounting, the viability statement and the disclosures on risk management.
The revisions are effective for audits of financial statements for periods commencing on or after 1 October 2014.
What's next for the Code?
The FRC usually reviews the Code every 2 years. Further changes to the Code are likely in 2016. In particular, as part of the UK's implementation of the Statutory Audit Directive and as a result of the Competition and Market Authority's review of the market for audit services. The FRC is also proposing a review of board succession planning and will review diversity issues in light of Lord Davies' target of 25% women on FTSE 100 boards by 2015. The FRC may also revisit whether corporate governance statements should be published online
Background to the Code
It is now over 20 years since the Cadbury Code was introduced. Principles-based corporate governance is now firmly established in the UK and has evolved over the last two decades into the Code. The idea may be entrenched but the economic collapse of 2008 and the numerous examples of reward-for-failure on executive remuneration have kept corporate governance under close scrutiny. The Code sets out standards of good practice in relation to board leadership and effectiveness, remuneration, accountability and shareholder relations. The Listing Rules require all companies with a premium listing of equity shares on the London Stock Exchange to report on how they have complied with the Code in their annual report and accounts, and to explain where they have not applied the Code. Other companies seek to comply with the Code on a voluntary basis.